This post was inspired by an exchange I had last month with my friend Steve Murphy, who used to work on the NYSE and is one of the most informed, thoughtful, up-to-date people I know on world affairs. He regularly mass-mails his musings on political events to a select list of friends—I like to call them Murph-o-Grams—and the one on Kim Jong-Il generated a discussion about the ways in which things like North Korea’s nuclear shenanigans get priced into the market.

One hears with some frequency about events, particularly risky ones, being “priced into the market,” but what does that actually mean? Who does the pricing? And how?

Here is the original Murph-o-Gram:

Kim Jong Il-tempered

How does one deal with an impudent baby who threatens to hold its breath until it dies? You let it. And so it is with North Korea’s Kim Jong-Il. Granted, his temper tantrums could have much more serious global consequences.

The “Dear Leader” is up to his same old tricks. The US has become better at ignoring his tactics and addressing his neighbors, who offer him the hope of refuge if he goes too far: China and Russia.

China has much to fear from a destabilized North Korea: millions of desperate refugees, a new government that may be even less responsive, loss of face internationally. Russia has much less to lose unless it turns out it belongs to the international network that has helped North Korea buy nukes. Even then, Russia seems not to care too much what the international community thinks.

The US seems to accept that North Korea is merely a stubborn regime that keeps its people unnecessarily impoverished. So long as we keep a close eye on it, allow China to determine whether action is taken, and do not give Russia an opportunity to feel superior, we have little to fear.

But this strategy of letting China take the lead in dealing with Kim Jong-Il has made it difficult for American political leaders to address the very real concerns of our allies, South Korea and Japan: they are playing along, but nuclear toys so close to home are not easily ignored. Obama is trying to do better than his predecessors by taking the issue to the UN…though considering the UN’s track record in dealing with bullies and megalomaniacs, Kim Jong-Il probably knows he has little to fear.

The financial markets mostly shrugged off the goings-on in North Korea, as well they should. Compared to everything else going on in the world, North Korea’s still-limited nuclear capabilities no longer rattle world markets, While the first nuclear tests conducted there did fray a nerve or two on global exchanges, repetition has dulled their impact.

North Korea only becomes a serious problem if it mishandles its nukes, or if China loses patience with Kim Jong-Il’s brinksmanship. So far, neither event has come to pass. What really matters in the markets now are signs of a rebound in GDP growth. As long as Dear Leader’s shenanigans pose no threat in that regard, North Korea remains little more than a carny sideshow as far as the financial world is concerned.

And here is the dialogue that followed:

Me: Could you explain something to me in slightly more detail: why isn’t Wall Street more spooked by the prospect of a madman waving nukes around like a kid with a water pistol? Why is there such a heavy discount on the nuclear threat from Kim Jong-Il, when a nuclear strike would seem to harm the world economy WAY more than WorldCom fudging its books by 1 cent to meet earnings expectations. (Not that WorldCom was right, but that Dear-Leader-with-the-Nukes is so wrong.)

Murph: To answer your question, I was kind of surprised myself. I came up with several reasons:

Boy who cried wolf syndrome

Pattern of only going so far also suggests a certain amount of rationality

Supply chain from South Korea/Japan is less important than it used to be

North Korea still cannot launch nukes successfully

Lack of alarm on the part of the US military(even during the North Korean launch a couple of months ago US military leaders were non-plussed)

Nuclear threat already priced into the market (based on nukes in Pakistan)

As for the WorldCom comparison, the standard financial analysis models in use at the time the scandal broke were highly dependent on the accuracy of SEC reports and on the trustworthiness of management. Outlier events like nuclear strikes were not given much weight in those models because they were (and still are) seen as a systemic risk—that is, part of the risk you are willing to bear just by entering the market. Finally, WorldCom did more than fudge a number—the company did not match revenues with liabilities, so the fear in the market was that there was more to the story.

As an observer, I agree with you: I am more concerned about loose nukes than I am about loose books, mostly because I never believed in the accuracy of accounting in the first place.

Me: Is there an economic solution to this problem? Any leverage the US (or the world community) can place on a guy who prints his own $100 bills by the stack?

Murph: Any “solution” runs into the same road block: China. China does not want a regime change in North Korea unless it can control it. Right now, China seems happy to have the North Korea “bargaining chip” at their disposal. This allows China to say to any country bordering the Sea of China: “The US may be more powerful than we are, but we share your geographical location and interests. Moreover, we can control North Korea–the US can not.”

The best the US can do is tolerate the situation, at least until there is ample provocation that can both galvanize the US and embarrass China.

The US is stepping up its attack against money laundering in large part to stop funding of terrorist activities, of which North Korea’s actions fit the definition. Along the way, they are picking up many tax cheats. By not allowing North Korea to pass counterfeit money, they are strangling the head rather than the body. The problem is, this approach takes time to be effective. On the plus side, it is hard for anyone to argue in favor of money laundering, so the US will catch no flack from the international community for attacking North Korea on this front.

Me: So I get your point that KJI looks like the boy who cried wolf—it’s hard to take him seriously now, and he seems to have a finely-tuned sense of where the boundaries of “going too far” lie…so he puts his toes right on the line, but goes no further.

Just to clarify, can you explain exactly how the risks posed by nuclear weapons (in North Korea, Pakistan or wherever) get “priced in” to the market, and by whom? Do analysts actually sit around modeling “chances of nuclear disaster” when making recommendations? Or do traders on the floor do the pricing-in? Or is it really several parties at once involved in the pricing-in process?

Murph: The nuke issue gets priced in several ways. The one way it does not get priced in is through traders, on the floor or otherwise. It gets priced in by “investors”—that is, by money managers, hedge funds, institutions, etc. It also gets priced in by companies, banks, and anyone else whose financial interest in pricing that risk accurately makes it cost-effective to undertake the expense of an Enterprise Risk Management operation (ERM). By and large, ERM divisions tend to be small; I’d guess that in general, they cost firms less than 1% of revenues.

Threats considered by ERM staff typically run the gamut from the mundane (inflation at 1-2%) to the highly unlikely (the French winning a significant military conflict). For the most part, though, ERM staff focus on events likely to have the biggest impact on a particular firm and its industry. If the firm is a manufacturer with a global supply chain, anything that might disrupt that chain receives the lion’s share of attention in ERM: that could range from resource scarcity, to weather, political unrest, and changing social norms. If the firm is strictly trading financial instruments, the focus will be more on economic issues, news events, reaction times (which involve technology like crackberries—remember when that service was disrupted?), and collinearities (i.e., as the US dollar gets stronger, the price of gold rises). The work of ERM is never quite done. There are all sorts of scenarios to think up and action plans to prepare.

So to protect itself and reassure analysts and investors, Nestlé might employ a few analysts who devise all sorts of ways their operations could be disrupted, including what scenarios would likely ensue and how the company could respond to each. For example, a malaria outbreak in Cote d’Ivoire would interrupt cacao shipments from Senegal to Christchurch (New Zealand), thereby limiting supplies to Sydney. Therefore, Nestlé might have in place a plan to buy excess capacity in Manila, for which they pay a monthly premium, almost like insurance. The premium would be paid to whomever was obligated to make the delivery of the cacao: it could be a storage firm holding the commodity on a “just in case” basis, selling it off as their obligation ends; or it could be a plantation owner who normally sells his crop to a local confectioner, but in a pinch will stop selling to the local and sell to Nestlé instead; or it might go to a government holding a monopoly on production of the commodity. You can see how this can get quite complex (and quite politically muddy) very quickly. This is where firms like Morgan Stanley step in to make a buck in return for simplifying matters: they can sell Nestlé a derivative based on malaria outbreaks in Western Africa, creating the same kind of “insurance policy” at lower cost.

As for money managers, especially macro investors like George Soros, they might make financial bets on the likelihood of certain events (the end of the war in Sri Lanka, or a nuclear strike) that threaten markets worldwide, rather than particular companies. So unlike an airplane manufacturer or a Nestlé, a money manager’s ERM strategy focuses on the outcomes of elections, the workings of legislatures, or general economic efficiency in a country or region. Macro investors look for movements on a global scale—like the flow of funds into India and into Central Europe—rather than fluctuations in the prices of individual stocks, This aggregate perspective on risk also means that money managers hedge differently than individual firms do. Instead of taking out “insurance” on the supply of cacao or other production resources, money managers hedge through placements in the currency, commodity, equity or bond markets.

But the really important thing about money managers’ view of risk is how they model it, and how that results in their seemingly blasé responses to disturbing news like nuclear tests by Kim Jong-Il. Money managers’ models treat risk in a much more general way than the ERM of individual firms. So when money managers model market risk to include factors such as “likelihood of a nuclear strike,” location assumptions are irrelevant: the overall likelihood of the strike remains constant no matter whether the threat du jour comes from Iran, Pakistan or North Korea. Furthermore, information about new threats, such as Pakistani nukes falling into Taliban hands, would be treated in the money managers’ risk models as a change only in the overall likelihood of a strike happening somewhere in the world—that is, an incremental change, rather than a cause for reevaluating the model.

These are highly simplified examples, since the real models in use often have thousands of variables, but here’s what it means for our subject, pricing in the risks posed by Kim Jong-Il and his nukes. While it’s widely assumed that he has some sort of nuclear capability, his threats (and tests) are at best loosely related to his actual likelihood of deploying the weapons. That’s why, while each of his threats may make the news, we can say that the actual risk he presents (in terms of deployment ) has already been “priced in” to most financial models.

Me: What exactly is the US government doing to prevent North Korea from counterfeiting dollars successfully? I know about the changes in the bill design, of course, but do you know whether the US is attacking the problem primarily at the level of technology (i.e., preventing North Korea from obtaining the engraving machines used by the US mint, or just changing the designs so much that it’s hard for counterfeiters to keep up?) or at the level of transactions (that is, once the money has been counterfeited, making it difficult to pass it off as legit)? Is North Korea the worst offender when it comes to counterfeiting, or does it have competition from the other fraud capitals of the world, like Nigeria? (By the way, isn’t it interesting that countries seem to specialize in types of fraud? In Nigeria, it’s the 419 scam; in North Korea, it’s counterfeiting; and god knows what else in other parts of the world…)

Murph: As for the counterfeiting, so far as I can tell, the Treasury wants to keep the fight as quiet as possible. They seem to be attacking the demand and distribution more than the supply. The ability to track money is highly refined. To be able to launder stacks of cash is very difficult. For a willing accomplice, the price is very high and reduces the incentive, unless the incentive is to destroy the dollar and the US. I do not think that is the intent in North Korea. The regime likes their luxuries too much.

The sophisticated nuclear sales group led by Pakistani nuclear scientist and arms dealer Abdul Khadeer Khan is not going to accept counterfeit bills. However, an Iraqi selling a Rocket-Powered Grenade on the street might be an unwitting victim. In any case, laundering that much counterfeit money would be very difficult. Compared to the money supply, which is around US$1.5 trillion, several billions of counterfeit is annoyingly acceptable. So while the US is certainly aware of and working toward stymieing counterfeiting (recall the freeze placed on all Macao bank accounts tied to North Korea in 2005) they are not looking for much publicity.

Of course, I could see an ironic situation where Hugo Chavez accepts North Korean counterfeit cash for payments—whether for Venezuelan oil or for any other transaction in which Venezuela might act as a middle-man—and then uses it to bail out Cuba…and round it goes, with only sworn enemies of the US trading on the assumed faith of a currency that does not exist. But that would be for the limited CSPAN audience.

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* To my chagrin, I will not win any originality points for this dreadful pun. I can only say that others have punned worse, and often, on this subject. Google “How Do You Solve a Problem Like Korea” if you dare.

** ERM can range from a curmudgeonly troll in the basement, to a simple software program, to an outsourced quarterly report, to a whole in-house division of PhDs in statistical modeling. How a company approaches ERM depends on the personality and sophistication of the management, including the board of directors. A financial services company can create an ERM strategy quite easily and cheaply by creating a spreadsheet of its positions and hedging the aggregate position of the firm. A simple example: say a firm is long on 10 stocks in the DJIA and short on 20 DJIA stocks; to hedge its risk, it should buy enough futures contracts to balance out its long and short positions, and have a plan in place to unwind the future position once the Dow positions are liquidated.

Here’s a more complex scenario showing why a firm might find it economically valuable to have an ERM in place, both for internal use and as a signal to financial analysts that the firm is stable and reliable, even in times of crisis. Say Boeing or one of the other airplane manufacturers actually studied the impact on the aerospace industry of a terrorist using a plane as a missile. And say their analysis showed major short-term disruption in air travel (a couple of days), followed by a period of greatly reduced traffic (like a 50% reduction in passengers for a few months), culminating in a steady climb back to pre-attack levels. So when a catastrophe like 9-11 happens, the firm can brief the analysts covering their stock, showing that the firm has a response plan in place, such slowing down spending but not cancelling all projects, stretching costs out until growth is expected to resume, etcetera. Having a clear plan in place would impressed analysts and investors, meaning that the firm’s stock dropped less than others in the industry One thing is certain, an effective ERM must have access to all the details of every division in the firm. As a recent example of doing this successfully, consider Goldman Sachs, which just reported its forecast-beating $3.44 billion profit for the second quarter of 2009. ERM was a factor in the firm’s ability to prosper in the midst of chaos and economic dire straits in the rest of the financial services industry. That’s because GS saw its exposure to sub-prime mortgages as a risk and hedged against it. For the first couple of of quarters, the hedging investment looked like wasted money, but eventually it paid off. (BH: Understatement of the year?)

About Economic Sociology

Brooke Harrington explores the social underpinnings of money and markets. Read more…